Are Canadian banks getting too expensive?

Canadian bank stocks have soared relative to their global peers, prompting investors to rethink their stakes in the world’s safest financial-services firms.

The S&P/TSX Commercial Banks Index is trading at a higher premium relative to the MSCI World Bank Index since at least 2006, according to data compiled by Bloomberg. The premium for Canadian banks surged to 37% on Sept. 6 and ended Wednesday at 32%. Canadian banks traded at a 30% discount in May 2009 and had the same price-earnings ratio as their global counterparts as late as Aug. 10, 2010.

“Canadian banks deserve a premium, I just think that premium has reached its peak,” Stephen Lingard, director of research at Franklin Resources Inc.’s Franklin Templeton Multi-Asset Strategies group, which oversees about $31.4 billion, said in a phone interview from Toronto. “We’re still basking in the glow of our significant outperformance, and that could be dangerous.”

The eight-company S&P/TSX Commercial Banks Index and the MSCI World Bank Index traded at about 11 times forecast earnings on Aug. 10, 2010. The S&P/TSX index traded at 10 times analysts’ profit estimates yesterday, versus 7.6 times for the world gauge, which had dropped to 7.4 on Sept. 12, the lowest since at least 2005.

The MSCI World Bank Index, KBW Bank Index of 24 U.S. lenders and Stoxx 600 Banks Index of European financial firms have each declined at least 49%, including dividends, since the end of 2007. The declines come amid investor concern that the European debt crisis, the prospect of another U.S. recession and low interest rates will crimp profits.

Soundest System

Canadian banks, which are part of a financial system judged the soundest by the World Economic Forum for four consecutive years, have returned 18% with dividends since 2007.

Relative to book value, Canadian banks are more than twice as expensive as U.S. banks and three times pricier than European lenders.

“The price-to-book comparison is out of line,” said Chris Wain-Lowe, who oversees about $200 million of financial shares at Portland Investment Counsel Inc. in Burlington, Ont. “If an investor has a two-plus-years outlook, when we believe banking will get back to more normal earnings levels, there’s far greater uplift in holding a well-diversified global bank than a Canadian bank.”

Buying Abroad

Wain-Lowe said he has sold shares of Royal Bank of Canada in the past three months and bought lenders in other countries, including New York-based JPMorgan Chase & Co., London-based Barclays Plc and BNP Paribas SA of Paris.

“I prefer to be in other safe havens versus those that are relatively expensive,” Vrouwes said in a phone interview from The Hague.

National Bank of Canada’s Altamira Investment Management was among investors to pare Canadian bank holdings in July and August as it sold Toronto-based RBC, Toronto-Dominion and Bank of Nova Scotia, according to Bloomberg data. MD Management Ltd., part of the Canadian Medical Association, sold 1.13 million RBC shares and added banks including New York-based Citigroup Inc., JPMorgan and London-based HSBC Holdings Plc, the data show.

Some investors still see value as the index of Canadian banks trades at 11.2 times trailing 12 months’ earnings, compared with a five-year average of 14.4, Bloomberg data show.

‘Special Case’

Anil Tahiliani, who helps manage about $1 billion at Calgary-based McLean & Partners, bought Scotiabank shares last week. He said the US$2 trillion in writedowns suffered by other countries’ financial firms since 2007 makes an international comparison based on price-earnings ratios misleading.

“You almost have to look at the Canadian banks as a special case given how strong they are,” Tahiliani said in a telephone interview. “They’re always going to trade at a higher valuation relative to other global banks. The other banks have so much credit exposure to Europe.”

Scotiabank Chief Executive Officer Richard Waugh said Canadian banks should be able to outperform global competitors and maintain their valuation premium.

“When we analyze our business model for all these changes in regulation, we’re not in Europe, we’re not in the United States,” Waugh, 63, said in an interview yesterday. “We don’t have the legacy assets that the Americans and Europeans have, or the litigation.”

‘Slow-Growth Environment’

Canadian lenders aren’t immune to what Royal Bank CEO Gordon Nixon this month called “significant headwinds” sweeping the global banking sector.

“We are operating in a slow-growth environment,” Nixon, 54, said in a Sept. 20 interview. “That’s what we’re going to have to be used to for an extended period.”

Profit estimates for Canadian banks will fall short of consensus over the “near- to medium-term,” Peter Routledge, a National Bank analyst, said in a Sept. 14 note.

“A big part of the premium that you’re paying for Canadian banks is not just stability and high capital and so on, but also a little bit more confidence in their ability to earn a required return,” Darko Mihelic, an analyst at Cormark Securities Inc. in Toronto, said in a telephone interview. “I don’t think, longer-term, the premium is sustainable because U.S. banks, and any other bank for that matter, will over time figure out how to make money and an appropriate return.”

Franklin Templeton’s Lingard said he would prefer to invest in places where “problems” are already discounted.

“At some point that could be European or U.S. banks, but it’s too early,” he said.

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